Central Banks Should Lean In Against Bubbles, BIS Official Says

The world’s major central banks should be more proactive about restraining excessive asset price increases rather than just trying to clean up the mess after the bubbles pop, according to a new working paper from Claudio Borio, head of the Monetary and Economic Department at Bank for International Settlements.

“For monetary policy, this means leaning more deliberately against booms and easing less aggressively and persistently during busts,” the author writes.

His approach runs contrary to the recent record of many prominent central banks including the Federal Reserve. During the housing boom preceding the financial crisis, top Fed officials raised interest rates in a series of small steps, while downplaying the possibility of a national real estate bubble that could deeply damage the economy. Since the crisis, Fed officials have argued that regulatory tools, not interest rate increases, should be applied as the first line of defense against possible market distortions.

Mr. Borio argues such action may be too timid to contain a world increasingly prone to bubbles in the wake of large-scale financial deregulation over several decades.

“Financial liberalization makes it more likely for financial factors in general, and booms and busts in credit and asset prices in particular, to drive economic fluctuations,” Mr. Borio contends. “The economy is propelled by loosely anchored perceptions of asset values and risks, critically supported by easier credit availability – one could say that it becomes an asset-backed economy.”

The issue is highly relevant for the Fed. Policy makers are expected to continue dialing down their bond buying next week. While officials have tied the pullback to recent economic improvement, they are watching carefully for signs the program could be fueling financial bubbles.

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